Friday, November 20, 2015

Six
reasons are typically cited as potential grounds for investor intervention.
Whilst it would be rare to act on the basis of one factor (unless it was
particularly unfavourable), an accumulation of factors may have such an effect.
Furthermore, institutional investors have a moral duty to use their power to
monitor the companies they invest in for the good of all investors, as
recognised in most codes of corporate governance. Institutional investors have the
expertise at their disposal to understand the complexities of managing large
corporations. As such, they can take a slightly detached view of the business
and offer advice where appropriate. The typical reasons for intervention are
cited below.

Concerns about strategy, especially when, in terms of long-term investor value,
the strategy is likely to be excessively risky or, conversely, unambitious in
terms of return on investment. The strategy determines the long-term value of
an investment and so is very important to shareholders.

Poor
or deteriorating performance, usually over a period of time, although a severe deterioration
over a shorter period might also trigger intervention, especially if the
reasons for the poor performance have not been adequately explained in the
company’s reporting.

Poor non-executive performance. It is particularly concerning when non-executives do not,
for whatever reason, balance the executive board and provide the input
necessary to reassure markets. Their contributions should always be seen to be
effective. This is especially important when investors feel that the executive
board needs to be carefully monitored or constrained, perhaps because one or
another of the factors mentioned in this answer has become an issue. Major internal control failures. These are a clear sign of the loss of control by senior management
over the operation of the business. These might refer, for example, to health
and safety, quality, budgetary control or IT projects. In the case of ZPT,
there were clear issues over the control of IC systems for generating fi
nancial reporting data.

Compliance failures,
especially with statutory regulations or corporate governance codes. Legal
non-compliance is always a serious matter and under comply-or-explain, all
matters of code non-compliance must also be explained. Such explanations may or
may not be acceptable to shareholders.

Excessive directors’ remuneration or defective
remuneration policy. Often an indicator of executive greed,
excessive board salaries are also likely to be an indicator of an ineffective
remunerations committee which is usually a non-executive issue. Whilst the
absolute monetary value of executive rewards are important, it is usually more
important to ensure that they are highly aligned with shareholder interests (to
minimise agency costs).

Poor
CSR or ethical performance, or lack of social responsibility. Showing a lack of CSR
can be important in terms of the company’s long-term reputation and also its
vulnerability to certain social and environmental risks.

(ii) Case for intervention

After
the fi rst restatement, it was evident that three of the reasons for
interventions were already present. Whilst one of these perhaps need not have
triggered an intervention alone, the number of factors makes a strong case for
an urgent meeting between the major investors and the ZPT board, especially Mr
Xu. Poor performance. The restated results were ‘all signifi cantly below
market expectations’. Whilst this need not in itself have triggered an
institutional investor intervention, the fact that the real results were only
made public after an initial results announcement is unfortunate. The obvious
question to ask the ZPT board is why the initial results were mis-stated and
why they had to be corrected as this points to a complete lack of controls
within the business. A set of results well below market expectations always
needs to be explained to shareholders. Internal control and potential
compliance failures. There is ample evidence to suggest that internal controls
in ZPT were very defi cient, especially (and crucially) those internal controls
over external fi nancial reporting. The case mentions, ‘no effective management
oversight of the external reporting process and a disregard of the relevant
accounting standards’, both of which are very serious allegations. Linked to
this, the investors need an urgent clarifi cation of the legal allegations of
fraud, especially in the light of the downward restatement of the results. Any
suggestion of compliance failure is concerning but fraud (down to intent rather
than incompetence) is always serious as far as investors are concerned.

Excessive
remuneration in the form of the $20 million bonus. It is likely that this bonus
was excessive even had the initial results been accurate, but after the
restatement, the scale of the bonus was evidently indefensible as it was based on
false fi gures. The fact that the chief executive is refusing to repay the
bonus implies a lack of integrity, adding weight to the belief that there may
be some underlying dishonesty. Furthermore, although the investors thought it
excessive, the case describes this as within the terms of Mr Xu’s contract. A
closer scrutiny of remunerations policy (and therefore non-executive
effectiveness) would be appropriate.

(b) Absolutist and
relativist perspectives

Absolutism
and relativism

An
absolutist ethical stance is when it is assumed that there is an unchanging set
of ethical principles which should always be obeyed regardless of the situation
or any other pressures or factors that may be present. Typically described in
universalist ways, absolutist ethics tends to be expressed in terms such as ‘it
is always right to . . . ’, ‘it is never right to . . . ’ or ‘it is always wrong
to . . . ’

Relativist
ethical assumptions are those that assume that real ethical situations are more
complicated than absolutists allow for. It is the view that there are a variety
of acceptable ethical beliefs and practices and that the right and most
appropriate belief depends on the situation. The best outcome is arrived at by
examining the situation and making ethical assessments based on the best
outcomes in that situation.

Evaluation
of Shazia Lo’s behaviour – absolutist ethics

Firstly,
Shazia Lo was correct to be concerned about the over-valuation of contracts at
ZPT. As a qualified accountant, she should never be complicit in the knowing
mis-statement of accounts or the misrepresentation of contract values. For a
qualifi ed accountant bound by very high ethical and professional standards,
she was right to be absolutist in her instincts even if not in her eventual
behaviour.

Secondly,
she was also right to raise the issue with the fi nance director. This was her
only legitimate course of action in the fi rst instance and it would have been
wrong, in an absolutist sense, to remain silent. Given that she was intimidated
and threatened upon raising the issue, she was being absolutist in threatening
to take the issue to the press (i.e. whistleblowing).

It
would be incompatible with her status as a professional accountant to be
complicit in false accounting as she owed it to the ZPT shareholders, to her
professional body and to the general public (the public interest) never to
process accounting data she knows to be inaccurate. An effective internal audit
process would be a source of information for this action.

Evaluation
of Shazia Lo’s behaviour – relativist ethics

It
is clear from Shazia Lo’s behaviour that despite having absolutist instincts,
other factors caused her to assume a relativist ethic in practice.

Her
mother’s serious illness was evidently the major factor in overriding her
absolutist principles with regard to complicity in the fraudulent accounting fi
gures. It is likely she weighed her mother’s painful suffering against the need
to be absolutist with regard to the mis-statement of contract values. In
relativist situations, it is usually the case that one ‘good’ is weighed againstanother ‘good’. Clearly it is good (an absolute) to show compassion and
sympathy toward her mother but this should
not have

caused her to accept the payment (effectively a bribe to keep silent). She may have reasoned that the continued suffering of her mother
was a worse ethical outcome than the mis-statement of ZPT accounts and the fact that she received no personalincome from
the money (it all went to support her mother) would suggest that she acted with
reasonable motives eventhough her decision as a professional accountant was defi
nitely inappropriate. Given that accepting bribes is a clear breachof
professional codes of ethics for accountants and other professionals, there is
no legitimate defence of her decision and herbehaviour was therefore wrong.

(c) (i) Speech on
importance of good corporate governance and consequences of failure

Introduction

Ladies
and Gentlemen, I begin my remarks today by noting that we meet at an unfortunate
time for business in this country. In the wake of the catastrophic collapse of
ZPT, one of the largest telecommunications companies, we have also had to
suffer the loss of one of our larger audit fi rms, JJC. This series of events
has heightened in all of us an awareness of the vulnerability of business
organisations to management incompetence and corruption.

The
consequences of corporate governance failures at ZPT. I would therefore like to remind you all why corporate
governance is important and I will do this by referring to the failuresin this unfortunate case. Corporate
governance failures affect many groups and individuals and as legislators, we
owe itto
all of them to ensure that the highest standards of corporate governance are
observed.Firstly
and probably most obviously, effective corporate governance protects the value of shareholders’ investment in a

company.
We should not forget that the majority of shareholders are not ‘fat cats’ who
may be able to afford large losses. Rather, they are individual pension fund
members, small investors and members of mutual funds. The hard-working voters
who save for the future have their efforts undermined by selfi sh and arrogant
executives who deplete the value of those investments. This unfairness is
allowed to happen because of a lack of regulation of corporate governance in
this country. The second group of people to lose out after the collapse of ZPT
were the employees. It is no fault of theirs that their directors were so
misguided and yet it is they who bear a great deal of the cost. I should
stress, of course, that jobs were

lost
at JJC as well as at ZPT. Unemployment, even when temporary and frictional, is
a personal misery for the families affected and it can also increase costs to
the taxpayer when state benefi ts are considered.

Thirdly,
because of the collapse of ZPT, creditors
have gone unpaid and customers have remained unserviced. Again, we should not assume that suppliers can afford to
lose their receivables in ZPT and for many smaller suppliers, their exposure to
ZPT could well threaten their own survival. Where the value of net assets is
inadequate to repay the full value of payables, let alone share capital, there
has been a failure in company direction and in corporate governance so I hope you
will agree with me that effective management and sound corporate governance are
vital. The loss of two such important businesses, ZPT and JJC, has caused great disturbance in the telecommunications
andaudit
industries. As JJC lost its legitimacy to
provide audit services and its clients moved to other auditors, the structure
of the industry changed. Other auditors will eventually be able to absorb the
work previously undertaken by JJC but clearly this will cause short-to-medium
term capacity issues for those fi rms as they redeploy resources to make good
on those new contracts. This was, I should remind you, both unnecessary and
entirely avoidable. Linked to this point, I would remind colleagues that it is
important for business in general and auditing
in particular tobe
respected in society. The loss of auditors’ reputation caused by these events is very unfortunate as auditing underpinsour collective confi dence in
business reporting. It would be wholly inappropriate for
other auditors to be affected by the behaviour of JJC or for businesses in
general to be less trusted because of the events at ZPT. I very much hope that such
losses of reputation and in public confi dence will not occur.

Finally,
we have all been dismayed by the case of Shazia Lo that was reported in the press.
A lack of sound corporate governance practice places
employees such as Ms Lo in impossible positions. Were she to act as whistleblower she would, by all
accounts, have been victimised by her employers. Her acceptance of what was
effectively a bribe to remain silent brings shame both on Ms Lo and on those
who offered the money. An effective audit committee at ZPT would have offered a
potential outlet for Ms Lo’s concerns and also provided a means of reviewing
external audit and other professional services at ZPT. This whole situation
could, and would have been, avoided had the directors of ZPT managed the
company under an effective framework of corporate governance.

(ii) The case for
the mandatory external reporting of internal controls and risks I now turn to the issue of the mandatory external reporting
of internal controls and risks. My reason for raising this as anissue is because this was one of the
key causes of ZPT’s failure.My fi rst point in this regard is that disclosure allows for accountability. Had investors been aware of the internal controlfailures and business probity risks
earlier, it may have been possible to replace the existing board before events
deterioratedto
the extent that they sadly did. In addition, however, the need to generate a
report on internal controls annually will bringvery welcome increased scrutiny
from shareholders and others. It is only when things are
made more transparent thateffective scrutiny is possible.

Secondly,
I am fi rmly of the belief that more information on internal controls would enhance shareholder confi dence and satisfaction. It is vital that investors have confi dence in the
internal controls of companies they invest in and increasedknowledge
will encourage this. It was, I would remind you, a lack of confi dence in ZPT’s internal controls and the strongsuspicion of fraud that caused the
share price to collapse and the company to ultimately fail.

Furthermore,
compulsory external reporting on internal controls will encourage good practice inside the company. The knowledge that their work will be externally reported
upon and scrutinised by investors will encourage
greater rigour inthe
IC function and in the audit committee. This will
further increase investor confi dence.

To
those who might suggest that we should opt for a comply-or-explain approach to
this issue, I would argue that this is simply too
important an issue to allow companies to decide for themselves or to interpret non-mandatory guidelines. It must be
legislated for because otherwise those
with poor internal controls will be able to avoid reporting on them. By specifying what should be disclosed on an
annual basis, companies will need to make the audit of internal controls an integral
and ongoing part of their operations. It is to the contents of an internal
control report that I now turn.

(iii) Content of
external report on internal controls

I
am unable, in a speech such as this, to go into the detail of what I would like
to see in an external report on internal controls, but in common with corporate
governance codes elsewhere, there are four broad themes that such a report should
contain.

Firstly,
the report should contain a
statement of acknowledgement by the board that
it is responsible for the company’s system of internal control and for
reviewing its effectiveness. This might seem obvious but it has been shown to
be an important starting point in recognising
responsibility. It is only when the board accepts
and acknowledges this responsibility that the impetus for the collection of
data and the authority for changing internal systems is provided. The ‘tone
from the top’ is very important in the development of my proposed reporting
changes and so this is a very necessary

component
of the report.

Secondly,
the report should summarise the processes
the board (or where applicable, through its committees) has applied in reviewing the effectiveness of the system of internal
control. These may or may not satisfy shareholders, ofcourse, and
weak systems and processes would be a matter of discussion at AGMs for
non-executives to strengthen.

Thirdly,
the report should provide meaningful, high level
information that does not give a misleading
impression. Clearly, internal auditing would greatly increase the reliability
of this information but a robust and effective audit committee would also be
very helpful.

Finally,
the report should contain information
about any weaknesses in internal control that
have resulted in error or material losses. This would have been a highly
material disclosure in the case of ZPT and the costs of non-disclosure of this
was a major cause of the eventual collapse of the company

I
very much hope that these brief remarks have been helpful in persuading
colleagues to consider the need for increased corporate governance legislation.
Thank you for listening.

Okay
now, this is for tutorial purposes, in the exam you are not really required to
give such elaborate answers.